How are Bond Yields Affected by a Firm’s Ties to the Federal Government?

Do bondholders benefit from connections with the federal government? We know that in the United States, there is ample evidence political connections confer benefits on firms. Firms which make PAC contributions, hire lobbyists, or employ former politicians are more likely to be bailed out[1], avoid enforcement[2], and receive lucrative government contracts[3]. However, many firms with political connections also rely on the federal government for the lion’s share of their revenue. These firms tend to invest less in physical/intellectual capital and grow dependent on their sales to the government[4]. As a result, their products are more likely to become obsolete and the firms become less credit-worthy than their competitors. Because there is a drawback to becoming too dependent on the federal government, the relationship between political connections and benefits to bondholders had remained a bit unclear.

In a recent paper I wrote with David Maslar, and Kuntara Pukthuanthong titled, “Political Connections, Government Procurement Contracts, and the Cost of Debt,” we explore whether firms with links to the US federal government have a lower cost of debt than firms without those links. If the bondholders perceive government contracts or political connections to either increase or decrease the desirability of their bonds, this perception will not only impact the prices of bonds in the secondary market but will also impact the firm’s cost of debt. We find that government contractors have a higher cost of debt than non-government contractors, but that political connections can help offset the higher cost of debt.

We identify two channels through which government contracting could increase the cost of a firm’s debt: by increasing cash flow volatility and by lowering capital investment. Firms which receive a large portion of their revenue from one source could become dependent on that source over time. If that source of revenue (in this case the federal government) cuts funding to the agency offering government contracts to the firm, then the firm will suffer. If the agency budget is volatile, this should increase the volatility of the firm’s cash flows as well.

Firms which receive a large percentage of their revenue from the federal government might expend more resources becoming proficient at bidding on government contracts, to the detriment of their other activities.[5] Over time, a firm’s management might choose to focus their bidding on government contracts rather than competing in the private sector. This could lead to their product offerings becoming obsolete and thus decrease their sales revenue and future viability as a firm.

Our results indicate firms with a larger percentage of sales to the federal government have a higher cost of debt (spread) than other firms. We use government contract data from 2004-2012 provided by the Federal Procurement Data System to test this relationship. In our main findings, a 1% increase in the percent of revenue received from federal government contracts leads to a 4.253 basis point increase in a firm’s cost of debt. In other words, all else held equal, a firm which receives 25% of its revenue from federal government contracts would have a spread a full percentage point higher than a comparable firm which received no revenue from the federal government.

There are several factors which could cause politically connected firms to pay either a higher or lower cost of debt than non-politically connected firms. Politically connected firms are more likely to be bailed out by the federal government[6], successfully complete acquisitions[7], win government contracts[8], and avoid fines imposed by the SEC[9]. We define politically connected firms as those firms whose affiliated Political Action Committees (PACs) make contributions to candidates in the House, Senate, and presidential races. Our PAC data are collected from the website of the Center for Responsive Politics.

Firms whose affiliated PACs make larger total contributions exhibit lower spreads than firms which do not make contributions. In economic terms, if a firm which has made the average PAC contribution were to increase their total PAC contributions by 1%, the firm’s spread (cost of debt) should decrease by 0.166 basis points.

There are several reasons why an increase in PAC contributions could lead to a decrease in a firm’s cost of debt. The first explanation for this finding is that an increase in PAC contributions to members of committees could influence the total funding contracting agencies receive or how those agencies are expected to use that funding. We find the cost of debt decreases for firms after they receive lucrative government contracts (cost-plus, no-bid, etc.). Second, PAC contributions to members of Congress could help a firm stabilize its future cash flows earned from government contracts. If the firm’s cash flow volatility is reduced or investors believe future cash flows will be reduced, this should reduce the firm’s cost of debt. We find support for this “Cash flow” hypothesis. Finally, politically connected firms might also make greater capital expenditures than non-politically connected firms. As capital expenditures and R&D expenses increase, firm innovation increases. Thus, the innovativeness of politically connected firms could be superior to non-connected firms and their ability to avoid default should increase. We find support for this “Capital Expenditure” hypothesis. Politically connected firms make greater capital and R&D expenditures than non-politically connected firms.

Next, we examine how being politically connected benefits government contractors. Since contractors receive a large percentage of their revenue from the government, the ability of PAC contributions to stabilize the volatility of this revenue earned should be more impactful the larger the percentage of sales a firm receives from government contracts. Our results indicate contractors who invest in PAC contributions see a greater reduction in the cost of debt than do non-contractors. In fact, our analysis indicates contractors who invest heavily in campaign contributions could offset the increased cost of debt because of being a contractor.

To ensure our results are robust, we examine whether firms whose contributions are to losing candidates see an increase in their cost of debt after the election losses. We also find firms whose change in total contributions to individuals in office after an election is greater than the median exhibit a decrease in their cost of debt. Essentially, firms whose political connections strengthen the most around an election see the greatest decrease in their bond spreads.

Finally, we examine whether connections to certain politicians are more valuable than contributions to other politicians. We split our sample of politicians into Senate, House, and presidential candidates and examine whether contributions to all these groups individually influences the cost of debt. We find contributions to both senate and congressional candidates have a significantly negative relationship with the cost of debt. We find contributions to presidential candidates have a negligible effect on the cost of debt by themselves, but contractors who make contributions to presidential candidates have a lower cost of debt than other contractors. Finally, we find firms which make greater PAC contributions to Appropriations and Budget committee members in the House and Senate have a lower cost of debt than firms which make lesser contributions to those individuals.

Our results suggest that while government contractors have a higher cost of debt than other firms in the same industry, connections to politicians act as a counterbalance. Furthermore, we discover that a decrease in cash flow volatility and an increase in capital investment due to being politically connected at least partially explains our results. That is, political connections decrease cash flow volatility and increase capital investment, which consequently reduces a firm’s cost of debt.

These findings suggest that political connections could help a firm reduce cash flow volatility by increasing the likelihood that the firm will be able to receive a loan, remain in a market, or receive a long-term government contract. The positive relation between firm-affiliated PAC contributions and capital and R&D investment also suggests that, while government contractors in general make fewer investments in novel projects, maintaining a connection to politicians could allow a firm to operate in a much more volatile regulatory environment.

Dr. Reza Houston is an assistant professor of finance at the Scott College of Business at Indiana State University

[5] Cohen, L., and C. J. Malloy. 2016. Mini West Virginias: Corporations as government dependents. NBER Working Paper, Available at SSRN 2758835

[6] See Duchin, R., and D. Sosyura. 2012. The politics of government investment. Journal of Financial Economics 106: 24-48.

[7] See Ferris, Stephen P., Reza Houston, and David Javakhadze. “Friends in the right places: The effect of political connections on corporate merger activity.” Journal of Corporate Finance 41 (2016): 81-102.